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Tuesday, February 12, 2013

What Venezuela’s Devaluation Really Means

Hugo Chavez, who is recovering from cancer surgery in Havana, ordered his government to weaken the exchange rate by 32 percent to 6.3 bolivars per dollar, starting Feb. 13, 2013.

The move was motivated to balance the budget deficit and contribute an additional 84.5 billion bolivars ($13.4 billion) in revenue, mostly from government oil sales transacted in dollars, according to Caracas- based research company Ecoanalitica.

There are several ways a government can reduce its budget deficit. It can decrease government spending, increase taxes, print more money or devalue its currency, if a significant part of government income is derived from exports (which in Venezuela's case, is its crude).

The devaluation will also impact domestic consumers, as imported goods (on which Venezuela is largely dependent) will increase significantly, adding to the possibility of an increase in cost-push inflation. Of course the government could have opted to add steam to the bolivar printing press, which also would have been inflationary. However, a devaluation seemed to be the more attractive option and the lesser of the two evils.

Successful monetary devaluations have been successfully orchestrated in the past, especially if an economy is contained in a deflationary environment: the UK and the “Sterling bloc” in 1931, the US in 1933, Sweden in 1992 and Argentina in 2002.

The devaluation opens up growth opportunities for industry that may be focused on exports, as the price of their goods would become competitive. However, as growth in the export market, for goods outside the crude industry are insignificant and government motivation to assist in developing this sector is limited, any expectations need be modestly inclined.

Some companies which are strongly entrenched in the export of goods through contracts, or who hold debt through their transactions as a creditor, could run up significant losses as they may be locked in to transactions or could hold bolivar bills, which are instantly devalued when converted to dollars or other currencies. Although it is surprising that they may not have embarked on action to hedge their positions, through forward currency cover contracts, at times the hedge is too costly, making the cover an inefficient option on a risk-return basis.